The Flash Crash: Why we panic and how to avoid it

by Pop on May 19, 2010

Sorry for the long absence. I was out of town on vacation. Back to the grind now though.

Panic in numbers.

“Safety in numbers” is a maxim rooted in our evolution. You see it in flocks of birds and schools of fish. Pods of bikers on the road. The proverb is even in the Bible in, well, Proverbs 11:14. “For lack of guidance a nation falls, but many advisers make victory sure.” Or translated roughly into non-lyrical English: Safety in numbers.

I’m sure that there did exist a time when it was totally necessary for large groups of humans to wig out at once. “Sabretooth tiger! Everyone go crazy!” And then people would run in random directions, confusing the human-eater and minimizing casualties.

But somewhere along the line, that very necessary proverb stopped translating to modern times. Business and the markets are perfect examples. Let’s take a look at our most recent panic attack.

Flash Crash

On May 6th, the market crashed and recovered in the span of a couple hours. Not a little blip. A huge 1,000 point drop in the Dow and a recovery. Some stocks, like Procter & Gamble, dropped more than 40%. It’s led the SEC to conduct an investigation and propose safeguards to prevent such extreme volatility from happening again.

We still don’t know what sparked it. The first theory was that someone accidentally pressed the wrong button and executed a mammoth trade. That one’s been ruled out, but there are five or six theories floating around now that have to do with imperfections in the systems that control the markets and activities in the futures markets.

Someday, maybe years down the road (it took a bit for people to figure out what caused a similarly steep crash in 1987), we’ll probably know what was to blame. But I guarantee you one thing, there was a trigger. And then the herd panicked. And a bunch of people who didn’t really know what was going on sold a bunch of shares at fire sale prices and are now regretting it.

When safety in numbers works against us

The Flash Crash of May 6th was unique in that it might have not even been a human that set investors off. But there’s no question that, in general, investors have been much more skittish the last couple years than usual. The volatility index (VIX is the ticker) measures market jumpiness. Check out this two year chart, keeping in mind that a measurement of 10 to 20 is “normal”.

Market fundamentals—for example, how much companies earn or what their growth prospects are—don’t change that rapidly. Only investors’ emotions do. Despite everything we know about buying and selling stocks, somehow it feels better doing like the herd, even if it means crashing and burning, than standing alone. I mean, it’s an evolutionary trait of Biblical heritage, right? How could you resist it?

You can’t. However, that doesn’t mean you can’t avoid it.

1. You can’t follow the herd if you can’t see the herd.

I didn’t execute a single trade on May 6th. I didn’t buy anything or sell anything. I doubt you did either. That whole crash and recovery was over before I even knew it had happened. Thank God. I had no time to panic.

Unfortunately, most crashes play out over several days and months. It grinds against you. You can resist one day, but as your portfolio evaporates and more people you know get out of stocks, you start to give in and shift your allocation.

The easiest solution to all this? Just don’t watch the herd. Shut off the television. Don’t discuss stocks with friends (in good times or bad times). Stop reading personal finance magazines even if all their advice is about how you shouldn’t panic and sell. Because frankly, half the times I’ve been told not to panic, I’ve started to get jittery. (“Don’t panic? Wait, you’re saying there’s reason to panic? You mean other people are panicking? What’s wrong with me? Why haven’t I panicked?”) If you’re a passive, age-based allocation-type investor—and most 401(k) investors are—there’s nothing more blissful to a portfolio than a complete disconnect from the news.

2. Play the contrarian—carefully.

A “contrarian” investor is one who sees what the herd is doing and tries to run counter to it. The idea is that while people’s emotions run them to one extreme or another, the contrarian can play the rational viewpoint and profit when the herd returns to reason.

That might be your gut reaction to turmoil. Stocks are cheap! I’ll buy more! Or whatever. The problem is that on all those surveys that financial advisors are required to give before investing your money, we say we’d buy more stocks if the market plummeted. But when it actually happens, we all sell stocks.

However, if you can stomach it, taking a chance on the opposite direction of the herd isn’t a terrible idea, if for no other reason than the fact that at least you’re trying to use reason and not following blindly.

3. Go ahead. Panic. Just take the decision making out of your hands.

I’m a big fan of do-it-yourself investing. Given that you’re already paying a percentage point or so to mutual fund managers, it pains me to see another percentage point or a few hundred dollars go to a financial planner.

However, financial planners are good at one thing: Saving you from yourself. Despite what a lot of planners might say, I don’t necessarily think it’s because they’re more educated about the vagaries of the market than you are. You can read a few particularly smart books and personal finance blogs and be as up-to-date on investing as you need to be to be reasonably successful.

No, financial planners are good because they’re not playing with their own money. That is, they don’t feel the same emotional connection to a drop in your portfolio as you do. And despite those Merrill Lynch commercials in the late 90s that talked about how great it is for your advisor to care a ton about your portfolio value, on the whole, I think it’s better for a planner who simply doesn’t feel the primordial fear you feel with a drop.

we say we’d buy more stocks if the market plummeted. But when it actually happens, we all sell stocks.

Not quite all of us so that. It depends on how much you lose in the crash. If you have a low stock allocation before the crash, it is easy to buy lots of stocks now that they are priced better. If you lost lots of money in the crash, good luck with the idea of now buying more of the asset class that caused the losses!

Buying when prices are better makes all the sense in the world. But it won’t work unless you prepare for the crash by lowering your stock allocation. It’s the decision to go with a low stock allocation prior to the crash that permits you emotionally to go with a high stock allocation following it.

I was kind of able to do this during this crash. I graduated from college 3 years ago and I didn’t have money to invest until the crash was underway. I bought my first stock in September, 2008, thinking the market had already crashed pretty hard. It kept on crashing, but thankfully I kept my money in stocks and ended up ahead of the market.

The same thing with my house. I bought it in March, 2008, thinking the housing market had already plummeted. Obviously it kept plummeting and I bought too early to qualify for the first time home buyer credit. I still hope I’m going to end up coming out ahead when I go to sell.

Leave a Comment

Name *

E-mail *

Website

Wordpress Hashcash needs javascript to work, but your browser has javascript disabled. Your comment will be queued in Akismet!